The big muddy

Par Robert Elman
le 1 mai 2008

There was Enron. In 2001 Enron
went into bankruptcy, but not before it had claimed the title as America’s most
innovative Company, six years running. Enron was instrumental bringing down one
of America’s leading accounting firms, Arthur Anderson. Its directors paid
millions of dollars in restitution, its CEO was convicted of fraud, along with
the CFO, investors lost billions of dollars, and innocent hard working
employees, lost their retirement pension, and much of their future.

This behemoth that reported $111
billion of sales of natural gas, oil and electricity, was discovered to be a
massive fraud of off book dealings and accounting fraud of historic
proportions.

We thought that with the new laws
that followed and the prison sentences imposed that, we would not be seeing
future “Enrons”

But the need and greed met on
Main Street, and the world is now confronted with the greatest financial crisis
since the great depression. In less than four years we went from the Dotcom
bubble to a real estate bubble.

To stimulate the economy, which
had fallen into recession, then Chairman Allan Greenspan, head of the Federal
Reserve, lowered interest rates, and kept them lower than ever before in the
period just before his retirement. The seeds for a new collapse, had been
planted

House prices were moving up
smartly, mortgage rates were not only low, they were ridiculously low. It made
no sense to rent property when you could purchase for little down payment and
in many instances, zero money down..

In the beginning demand for
property began to rise smartly, then sharply, then prices went vertical.

Everyone wanted in on the action.
For every desire there was someone to fulfill the wish. I have been in the
investment field for almost 40 years, and I had never heard of anyone being
able to borrow money below the prime rate with zero money down. It meant
exactly what it spoke to. Demand for real estate skyrocketed

From vertical, home prices went
into the stratosphere, with annual increases of 25-30% not unheard of in places
like California, Florida and Nevada.

Gary Shilling chillingly
predicted the following in 2006 “I am convinced that the housing bubble is
gigantic and will burst before long with massive implications here and abroad.
In fact, it's the key to the global economic outlook”

That, was only the beginning. For
this drama had many moving parts.

The culprits included everyone
from the banks, mortgage companies, hedge funds, monoline insurers, real estate
flippers, and those desperate to own a home at any cost.

Banks loan money at low rates.
Banks package mortgages and sell these new instruments to creative resellers,
who add other debt, and sell these to hedge funds, who repackage, leverage, and
then sell again and again and again...

Once relieved of the mortgages
and flush with cash, the banks are able to repeat and repeat this process.
Ditto for the hedge funds et al. With rising home prices and continued low
interest rates, homeowners were flush with cash obtained through home equity
loans and home refinancing.

Not only were mortgages issued at
subprime rates, but also in many cases, the valuations were inflated, which
resulted in mortgages being issued for property worth less than the real value.

Once the market began to start
its swoon in 2006, it did not take long for the first rung of this false ladder
of homeowners to begin to throw in the towel. No one likes to pay down a load
whose value is higher than the worth of the underlying asset.

And so we began to witness what I
call the 9/11 of real estate. As each level of equity ownership slipped below
the positive equity line, it became untenable for the debtor to remain in the
game. They either threw in the keys, or were foreclosed.

We now began to witness the
impact of negative leverage. Home prices turned down dramatically and as each
level of ownership slipped underwater, the subsequent level approached that
point of no return.

In my next article, I shall speak
to the issue of debt insurers, and what roll they played in this, the worst
credit crisis since the great depression.